The Emirates’ economy has recovered much of the ground it lost in 2008. The country’s banks are taking advantage by growing strongly. Is there a danger of another round of overheating?Published in Euromoney, September 2014

As political turmoil convulses more countries around the Middle East and north Africa, there is at least one corner of the region where people tend to see more opportunity than threat. The UAE, and more particularly Dubai, plays a valuable role as a safe haven, drawing in both money and talent from countries that are less stable, more conservative and with weaker infrastructure.

That helps to underpin a lot of other economic activity in the UAE, boosting demand for things like real estate and consumer goods, and it has helped to pull the country out from the slump it suffered in 2008 and 2009. Many of the bigger public and private companies have now rescheduled their debts or, in a few cases, paid them off entirely; real estate prices have largely recovered, and tourism and trade have both continued to grow.

It is not just international factors that are providing the impetus for the recovery though. High oil prices mean the Abu Dhabi authorities also have plenty of cash to recycle through the economy in infrastructure projects. All this helped the economy to grow by 5.2% last year, according to the IMF, and although growth is expected to slip this year it will still remain a healthy 4.7%.

This benign economic environment provides fertile ground for banks, and the signs so far this year suggest they are entering a period when their key metrics will be moving in the right direction.

"I’m positive about the development of the UAE economy, but clearly there is major geopolitical volatility in the region," says Peter Baltussen, CEO of Commercial Bank of Dubai (CBD). "However, in the past that has helped Dubai and the UAE to position itself as a safe haven and I expect that will also happen in this case."

His bank reported a net profit of Dh296.3 million ($80.7 million) for the first half of this year, up 18% on the same period last year. Assets, deposits and loans all also increased, which Baltussen attributes to the strength of the wider economic environment. "The main reasons are top-line growth, driven by a growing economy," he says. "Hence the higher loan and deposit volumes and fee income, as well as an improving loan-book quality."

Other industry figures take a similar line, saying there is growth in all the key areas. "All sectors, including corporate, retail and commercial, have seen strong performances," says Hussein Al Qemzi, group CEO of Noor Bank. "If you look at banks’ results for the first half of the year, it points to increasing profitability and improving asset quality. On the retail side, banks are witnessing consistent growth in deposits and lending, with a steady decline in non-performing loans. In fact, provision coverage ratios have improved for all banks. Trade finance, brokerage, retail and lending related fees have also contributed to a stronger balance sheet."

As Al Qemzi suggests, the financial statements from the first half of the year make pleasing reading for the country’s bankers. Almost across the board, banks have been posting strong growth in profits; double-digit gains are the norm, not the exception.

Some Islamic banks appear to be doing particularly well. Noor Bank more than doubled its profits for the first quarter, reaching Dh85 million, compared with Dh31 million for the same period last year, and Dubai Islamic Bank’s first half profits climbed by 81% to Dh1.3 billion. Others could not match that, but still put in strong performances. Mashreq Bank, Abu Dhabi Islamic Bank (ADIB), Emirates NBD, First Gulf Bank and United Arab Bank (UAB) all posted profit growth of between 20% and 45%.

The picture for deposits and loans is more mixed. Growth in these areas was in single digits at many of the larger banks such as Abu Dhabi Commercial Bank (ADCB), ADIB, CBD and Emirates NBD and even fell slightly at First Gulf Bank. At the other end of the scale some of the smaller banks such as UAB and Emirates Investment Bank saw very rapid growth.

"We’re certainly seeing an upbeat operating environment, with solid growth prospects for the UAE economy," says Redmond Ramsdale, country director for bank ratings in the UAE at Fitch Ratings. "There is significant government spending on things like infrastructure and there are continued high oil revenues and the non-oil sector, particularly in Dubai, is expanding. All of the banks are benefitting from this improving operating environment."

One of the main benefits emerging from this stronger economic environment is that some companies have been able to pay back loans as a result of the enhanced cash flow being generated by their businesses.

That was the case with Nakheel, a Dubai-based property developer, which paid back Dh7.9 billion in bank debts in August, up to four years ahead of schedule. Reports from the region in late August suggested that Dubai World was also close to agreeing a restructuring of more than $10 billion of its debts.

Such developments have helped banks to transform the health of their loan books over the past year, opening the way for more lending. "The banking sector in recent years has been impacted by low credit growth and high provisioning, which looks to have peaked last year," says Khaled Sifri, CEO of Emirates Investment Bank. "The sector seems to be moving beyond the days of the financial crisis. Banks are now more willing and capable to lend in all sectors."

However, as many are quick to point out, the damage the downturn caused is still a fresh memory, and banks are taking a more cautious approach today than in the past. They also know that, despite recent progress, not all issues have been dealt with. London-based Capital Economics pointed out in a research note issued in late August that "While the debt repayment profile is now less onerous, the overall bulk of debt remains extremely large, meaning it is probably too soon to declare that [Dubai’s] problems are completely behind it."

In many cases the debt restructuring that has been agreed has taken the form of bullet repayments going out as far as 2024. While the interest on these loans is being paid off, the principal remains outstanding, so there is always the chance of defaults in the future, although the risk is judged to be fairly low by the main credit ratings agencies.

The trick for the UAE’s banks will be to remain vigilant. That can be hard to do if they become distracted by all the potential profits to be made in a fast-growing market, but senior industry figures are adamant things will be different this time.

"The industry should be watchful of repeating the excesses of the past," says Shayne Nelson, group CEO of Emirates NBD. "The mistakes which banks made during the last cycle should not be repeated, and banks should do their full diligence before advancing loans to projects or companies. I do believe the banks are better skilled, with more robust risk departments."

The progress made to date means that the banks themselves have been able to repay a lot of the aid they were given by the government during the crisis. Emirates NBD, for example, paid back its outstanding Dh4.8 billion in July and US research firm IHS estimates that more than half of the Dh70 billion injected into the UAE’s banks at the height of the crisis has now been repaid.

One problem the banks face as they work through the rest of their problem loans is that the economy is dominated by government spending and a small number of large, private companies. This is not particularly unusual in small, developing economies, but it poses a continuing risk.

"This market is very concentrated, and if something goes wrong you can end up with some seriously large impaired loans," says Ramsdale. "It’s the nature of the market and part of being a developing, emerging market. This is also true on the liability side with large deposits. Our general view is that government deposits are quite sticky, but you don’t know what the situation is with a large corporate deposit. If something goes wrong it could be withdrawn."

It is hard to see how these issues can be addressed in the short or medium term as they reflect the structure of the wider economy. There are different risks when it comes to consumer finance, however, which the government has been trying to offset through a series of policy measures.

Among them are caps on the amount banks can lend to consumers for mortgages. These range from 60% to 80% loan-to-value ratios depending on whether it is a first or second home and whether the borrower is a local or an expat, although there is a tighter limit of 50% for all off-plan purchases. This appears to have helped to calm down the real estate market, which was showing worrying signs of overheating last year.

Another initiative by the government has been to launch an office covering consumer loans, the Al Etihad Credit Bureau, which is expected to start issuing its first consumer credit reports any day now. This could lead to a slowdown in the consumer loans market as banks gain a better idea of their customers’ financial circumstances and adjust their lending policies to fit.

Just how temporary the slowdown lasts remains to be seen, but the UAE’s banks have finding plenty of room for growth in retail loans in recent times. And notwithstanding the impact of the credit bureau, it seems likely that more banks will put more effort into their retail businesses in the future.

"Predominately the banks are universal banks," says Ramsdale. "A lot of them have substantial corporate businesses, but there are good yields in retail banking, so you will probably see a slight migration to retail for yield."

One segment of the retail market that often gets mentioned as particularly promising is Islamic banking, particularly in Dubai. This is true for conventional banks with an Islamic window as much as for pure-play Islamic institutions. Their motivation seems to stem at least in part from wanting to line up with the stated aim of the ruler of Dubai, Sheikh Mohammed bin Rashid al Maktoum, to turn the city into a global Islamic financial services hub.

"We are in the process of expanding our Islamic banking department and the range of Sharia-compliant products and services we offer," says Paul Trowbridge, CEO of United Arab Bank. "In this sector, Dubai is therefore a crucial market for us, though there is also plenty of potential for Islamic banking growth elsewhere."

However, for the market to grow as much as everyone is hoping, some changes will be needed. Al Qemzi, whose bank used to be known as Noor Islamic Bank until it dropped the middle word in January, says there are good opportunities, but the perennial problem of a lack of commonly agreed standards remains.

"After the global financial crisis, large segments of the world’s consumers are sceptical of the conventional banks and are therefore hungry for an alternative that is ethical, transparent and robust and able to meet their various needs," he says. "Islamic banks offer that alternative, though it must be pointed out lack of standardization has held back Islamic finance in general."

Beyond the retail market, there are signs of growth in other areas too, including the equity and debt capital markets, although the signals are often rather more mixed.

In terms of the stock market, the number of initial public offerings in the pipeline appears to be increasing, helped by the promotion of the UAE from frontier market to emerging market status by indexing company MSCI in June. Many of the companies planning to list are linked to the real-estate sector, including Emaar Malls, the shopping centre subsidiary of the local property developer Emaar, as well as Damac Properties.

However, the market has been volatile this summer, which might spook some investors and companies thinking of listing. At the heart of the problem was the local construction firm Arabtec. Over the course of the summer one of its largest shareholders, the Abu Dhabi government-owned Aabar Investment, reduced its stake in the business and its chief executive Hasan Abdullah Ismaik resigned. As a result of the instability, Arabtec’s share price lost 61% of its value in June, wiping out almost $3.9 billion, before recovering by 63% on the back of its second-quarter results the following month.

The volatility also partly reflects the fact that the market had risen by around 150% in 18 months, so some profit taking was all but inevitable. Even so, a more stable market would be beneficial.

The situation might be helped if there was some consolidation in the sector, which remains fractured. There are currently three stock markets within a 100-mile radius – the Abu Dhabi Securities Exchange (ADX), the Dubai Financial Market (DFM) and the offshore Nasdaq Dubai. A merger between the first two of these has long been mooted and would be welcomed by many in both cities.

In the meantime, there seems to be as much competition as cooperation between Dubai and Abu Dhabi, something that will be accentuated by the impending launch of Abu Dhabi’s own financial centre, the Abu Dhabi Global Market, to rival the Dubai International Financial Centre (DIFC).

Development of the local debt capital market is also at an early stage, but some senior figures have high hopes.

"Though in a nascent stage, we are seeing more activity and acceptance by corporates and business groups of using debt markets as a means of raising financing as opposed to traditional loan products," says Nelson. "We believe this is good time to develop regional local-currency capital markets and we are focusing on this through Emirates NBD Capital."

Certainly the market appears to be growing pretty strongly, albeit from a small base. Issuance of bonds, sukuk and syndicated loans across the Middle East and north Africa was worth Dh328 billion in 2013, compared with Dh208 billion just two years earlier. In the first half of this year a further Dh182 billion was issued.

As Nelson notes, the growth in such instruments is partly at the expense of the corporate loans business. Indeed this latter part of the market is particularly competitive at the moment. Nelson told an analysts and investor conference call on July 24 that "some transactions we have just let pass … because for us if we’re not getting the right return on risk capital and we can’t see any other ancillary business to increase the yield then, for us, it is not really worth doing the transaction."

Other senior banking executives agree, with one saying that the changes in the corporate loans market are an important trend for the sector and something that is unlikely to change in the near future.

"In wholesale banking, one of the key themes we are seeing in the UAE is a spread compression as borrowers take advantage of excess liquidity to refinance existing debt at lower levels," says the banker. "Given the accommodative stance of the US Federal Reserve and other global regulators combined with the UAE’s perceived status as a regional safe haven, we expect this trend to continue in 2014, placing pressure on banks’ interest income."

Different banks will of course have differing priorities, and clearly some see enough value in such deals to want to move ahead with them. However, it raises the question of if, despite the overall growth in the market, there is enough activity to go around. Al Qemzi for one thinks that the UAE has too many banks.

"The banking sector is getting healthier by the day. That said, the UAE banking sector is overbanked. I foresee a time when there will be some consolidation, but it will be market-driven rather than regulation-driven," he says.

There has already been some consolidation in recent months. During the second quarter of this year the central bank gave approval to ADIB to take over the retail business of Barclays in the UAE, a transaction that will bring more than 115,000 new customers to ADIB.

While some other smaller or weaker banks might disappear in the coming years, the stronger banks should continue to reap the benefits of the growing economy. And as they gain in self-confidence and balance sheet strength, some are also likely to look abroad to expand. Emirates NBD acquired the operations of BNP Paribas Egypt in 2013 and has operations in Saudi Arabia, Qatar, Singapore and the UK, as well as representative offices in Indonesia, India and China. It says it continues to evaluate opportunities to expand into other markets.

Others are also looking abroad. Dubai Islamic Bank says it hopes to have its Indonesian and Kenyan operations ready for launch this year and Noor Bank says it is actively seeking new opportunities in Europe and in southeast and central Asia.

As well as bringing in new sources of revenue for the banks, such moves should also help to cement trade ties between the UAE and these other markets. Given the central role that trade plays in the economy, particularly for Dubai, the international ambitions of the country’s banks will be welcomed by the UAE authorities.

But for all this to be sustainable the overriding need is to ensure that the economy does not overheat once more. That will require a defter touch than was shown during the last boom and bust, but at least more people appear aware of the dangers this time around.